article 12-31-2013

Royce SMid-Cap Value Fund Manager Commentary

We were not happy with the calendar-year return for Royce SMid-Cap Value Fund. While the Fund posted a decent performance on anabsolute level, it fell far short of its small- and mid-cap benchmark. The Fund rose 22.9% in 2013, lagging the Russell 2500 Index, which increased 36.8% for the same period.

SMid-Cap Value was behind its benchmark in each of the year’s four quarters, providing only limited participation in the bull market that spanned nearly all of 2013. The bulk of the Fund’s relative disadvantage came in the first quarter, which saw a return to market leadership for those areas of the market with more defensive or high-yielding characteristics. This left the portfolio at a disadvantage from the beginning of the year as our contrarian positioning continued to favor more economically sensitive and cyclical businesses at a time when fears persisted about the general health of the global economy. It was not entirely surprising, then, that the Fund got off to a slow start in the year’s dynamic first quarter, managing an increase of only 4.4% compared to the 12.9% advance for its benchmark. This upswing then gave way to more volatility as macro concerns surfaced that stymied both fixed income and equity investors. Credit tightening in China orchestrated by its central bank to address the excessive speculation in the housing market and unchecked lending in its shadow banking industry once again raised important questions about the sustainability of that nation’s remarkable growth rate. Perhaps more significantly, Fed Chairman Ben Bernanke surprised financial markets in June by signaling that the central bank would taper the pace of its monthly bond purchases. A sharp rise in the 10-year Treasury rate during May and June also worried investors.

What distinguished 2013 from the previous three calendar years was how quickly and easily the domestic equity markets shook off these concerns. Second-quarter returns were clearly more subdued—SMid-Cap Value gained 0.4% in the second quarter versus a 2.3% increase for the Russell 2500—but still positive. The market then resumed its feverish pace in the third quarter, when the Fund advanced 8.8% compared to 9.1% for the Russell 2500. Although a mini-wave of volatility hit the markets in mid-December, the fourth quarter ultimately proved only slightly less bullish than the first and third. The Fund gained 7.8% in the year’s final three months versus 8.7% for the Russell 2500.

Six of the portfolio’s eight equity sectors posted net gains for the calendar year. Information Technology led by a sizable margin, followed by a strong contribution from Industrials. Financials and Consumer Discretionary also posted notable net gains. Materials and, to a lesser degree, Health Care were in the red. The former sector is home to the metals & mining group, which housed a disproportionate number of “Good Ideas at the Time”—five of the Fund’s 10 largest detractors were precious metals & mining businesses, which were a bright spot for the portfolio in 2010 and the first half of 2011. Most of these companies could not shake off the negative impact on revenue and stock prices of the respective 36% and 28% drops in silver and gold prices in 2013. We sold our shares in Hochschild Mining in December after further declines in its share price and did the same in October with Pretium Resources. We built our stake in Pan American Silver thinking that this well-managed business was better positioned for an eventual turnaround.

In the Health Care sector we also added to our shares of Myriad Genetics. The company performs molecular diagnostic tests, specializing in genetic testing for cancer (it’s also a market leader in the breast cancer gene tests). The company faced several headwinds in 2013: reimbursement change concerns from payers, a Supreme Court decision in June that held that human genes cannot be patented, and new competition in the breast cancer gene testing
market. This led its stock to fall, though the company retained its patents on certain genetic testing processes. While reimbursement issues remained unresolved entering 2014, we think that the quality of its predictive tests remains the industry’s gold standard and that the firm is more than capable of holding onto market share in this important healthcare niche. We also like much of its existing and emergent pipeline of new products and services.

The Fund’s two largest holdings at year-end also topped our list of net-gaining positions. Hard disk drive maker Western Digital is one of two firms that dominate disk drive production worldwide. Its core business, which involves solutions for the collection, storage, management, and protection of digital content, has long interested us. The company made several savvy acquisitions in 2013, including Virident, sTec, and VeloBit. These moves made Western a stronger player in both the hard disk drive and flash technology markets, in addition to its growing presence in cloud storage technology. Helmerich & Payne provides contract drilling of oil and gas wells in the Gulf of Mexico and South America and also operates land and platform rigs. The company continued to leverage its technological leadership in the drilling rig business into market share gains as E&P (exploration & production) companies upgrade their fleets to improve drilling efficiencies and lower their total well costs.

Top Contributors to 2013 Performance

Western Digital 3.56%
Helmerich & Payne 1.96
Thor Industries 1.50
Jacobs Engineering Group 1.45
Westlake Chemical 1.35
1 Includes dividends

Top Detractors from 2013 Performance1

Hochschild Mining -1.38%
Pan American Silver -1.03
Pretium Resources -0.89
Myriad Genetics -0.79
Sprott -0.63
1 Net of dividends

Average Annual Total Returns as of Quarter-End 12/31/13 (%)

  QTR YTD 1YR 3YR 5YR Since
SMid-Cap Value 7.83 22.91 22.91 7.86 15.27 6.02 9/28/2007
Russell 2500 8.66 36.80 36.80 16.28 21.77 8.00 N/A

Annual Operating Expenses: Gross 1.90% Net 1.35%

Current month-end performance may be obtained from our Prices and Performance page.

Important Disclosure Information

All performance information in this Report reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Gross operating expenses reflect gross total annual operating expenses for the Service Class and include management fees, 12b-1 distribution and service fees, and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Service Class’s net annual operating expenses at or below 1.35% through April 30, 2014. Regarding the two “Good Ideas” tables shown above, the sum of all contributors to, and all detractors from, performance for all securities in the portfolio would approximate the Fund’s performance for 2013.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 2013, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds' portfolios and Royce's investment intentions with respect to those securities reflect Royce's opinions as of December 31, 2013 and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Royce-managed portfolio in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small- and mid-cap companies, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) In addition, as of 12/31/13 the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. The Fund may invest up to 35% of its net assets in foreign securities, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2500 Index measures the performance of the 2,500 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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